Volatility Index Gears Up

The Chicago Board Options Exchange (CBOE) Volatility Index is the market’s expectation of 30-day volatility which is essentially constructed from a wide range of options calculated from both the strike prices of calls and puts based on the S&P 500 index. What you will need to take away from this key market indicator is that it represents “investor fear” in the marketplace and is considered to be a good measure of market risk. Take a look at the chart below.

In this four-year monthly chart, we can see the big picture. It’s astonishing to think that the VIX traded between roughly $10 and $30 per share for such a long time. But like the cork in a nice bottle of champagne, don’t be knocked blind when she pops!

And that’s exactly what happened in September of 2008. You see, the VIX has an inverse relationship with the market. If the Dow tumbles, the VIX climbs higher and vice versa.  And if you recall, the major indices broke down past major support around this time frame.

What you see in the chart above reflects a technical pattern us chartists refer to as a bullish “flag” pattern. Similar to a flag that you may have hanging outside your own home, there’s a pole (recent bullish move) and then there’s the flag itself (space between the diagonal lines in black representing consolidation). As an investor, if you see this pattern, ask yourself one important question: What direction was the trend prior to consolidation? In this case it was bullish, or in an overall upward trend.

In an uptrend, these pullbacks represent the ratios of natural progression. For example investing behavior tends to repeat itself in patters: two steps forward, one step back or three steps forward, two steps back or five steps forward and three steps back. The point of this argument is to simply say that the recent pullback should be viewed as a buying opportunity. Not only was there a successful test of the breakout near $30, but we are quickly approaching upper support in the flag near $50-$53. If the VIX manages to push past this price range on high volume, the longs will be in good shape.

In the weekly chart of the VIX below you’ll notice that the actual resistance is somewhat closer to $53/share. The monthly chart makes it somewhat difficult to discover just where exactly these key points of support and resistance. At any rate, this is a perfect example of why we analyze the bigger picture before diving head first into the more exciting shorter-term market waters.

From looking at this chart you should be able to see how a breakout past $53 could easily clear the way for a good run up to $80, which would approximate out to a 51% return on your money. Unfortunately, you can only play the options on this one. Since we have yet to break this barrier I would caution you to be patient and wait to make your move. In the chart I have circled an area of minimal concern to the overall bullish picture I paint. It is a small gap that is likely to fill in the coming days since the hourly chart looks a bit overbought at the moment.  Again, wait for the price to push above $53 on higher than average volume before considering a call option on the VIX.

Good Investing,

Stanley Barnes
Analyst, Chart of the Week